Aegis Capital Corporation
Research Comment Precious Metals

With Paper Money, Confidence is Suspicion Asleep

Barry Downs and Bill Matlack
January 3, 2005

Former Prime Minister of Great Britain, Benjamin Disraeli, described confidence in money as suspicion asleep. In the world of irredeemable paper money, which has existed for over thirty years, the confidence issue is gradually coming to the forefront, especially with the US dollar, the world's reserve currency. The implications for Americans are profound.

Mr. John Exter (the father-in-law of the senior author of this commentary), retired economist and central banker, warned 34 years ago when Nixon closed the gold window to foreigners that the world had embarked down a treacherous road when it chose an IOU nothing paper money system with floating exchange rates. He envisioned an era of severe dollar debasement and ultimate repudiation of the dollar as a store of value, which would then eventually undermine confidence in the global paper money system. The dollar's problems have taken center stage, and suspicion has awakened.

In a $40 trillion world economy, the global irredeemable paper money system has mushroomed into a foreign exchange market (FX) where the turnover of currencies exceeds $1.5 trillion daily, according to the Bank of International Settlements. In other words, almost $550 trillion in foreign exchange transactions occur annually, compared with $7.5 trillion of annual turnover on the NYSE.

The foreign exchange market, which dwarfs all the worlds' financial markets, is an inter-bank or inter-dealer market based on a network of hundreds of major banks across the globe. Major foreign exchange centers are London (50% of the market), New York, Tokyo, Zurich, Frankfort, Hong Kong, Singapore, Paris, and Sydney. Trades above $1 million constitute the institutional side of the market, while those below $1 million represent the retail side.

FX players are typically governments and central banks, commercial and investment banks, hedge funds, businesses, consumers, investors, and speculators. Of all FX transactions, 85% involve the seven major currencies: US dollar, Japanese yen, Swiss franc, British pound, euro, Canadian dollar, and Australian dollar.

Because the US dollar has been the world's dominant reserve currency for over 60 years, the American mindset seems to be that the reserve currency status is secure and permanent, regardless of the America's irresponsible economic policies and resulting economic imbalances. It seems to have been forgotten that over the past couple thousand years, dominant international currencies have come and gone.

Without drawing much attention from American mainstream economists and politicians, the US dollar's position as a reserve currency has diminished from 80% thirty years ago to only about 65% currently, and that figure seems likely to continue down as the euro, for the time being, is becoming the more preferred currency. After all, the euro area represents a large economy, not much smaller than the US, and is the world's biggest exporter. It has financial markets deeper and actually more liquid than the US, and the euro area is a net creditor while the US is a net debtor nation with a history of using currency devaluation to reduce external deficits. To say that the US has undermined its world reserve currency position is an understatement!

Up to now, foreign central bank intervention as buyers of dollars has kept the dollar from falling a lot lower. But with still some $3 trillion of foreign exchange reserves still sitting in central banks around the world, when the selling really begins, the dollar will slide dramatically and financing America's current account deficit will become difficult.

Through mid-2004 those central banks holding the most dollars were financing 3/5 of the US deficit. In fact the global foreign exchange reserves in dollars (65%) have risen $1 trillion over the past 18 months, not because the US economic prospects are so good but because US dollar purchasers are attempting to hold down their own currencies for competitive trade purposes.

The large capital inflows have financed the American consumer buying binge and have expanded the deficit and the current account deficit currently at 6% of GDP is twice the size of the deficit in the late 1980s when the dollar fell sharply. Moreover in the 1980s the US was a net foreign creditor but today has net foreign liabilities, which by year end should reach $3.3 trillion or 28% of GDP. While the dollar has traded recently at around five year lows against the yen, Russia's central bank has further shaken the confidence in the dollar by hinting that it is considering diversifying from dollars to euros.

The twelve nation Euro fell from its 1999 debut to $.82 in 2000, but since then has risen 63% against the dollar. Adjusted for inflation the US dollar, however, is still not cheap even with its recent declines against the yen and Euro.

The dollar's real trade-weighted value against a broad basket of currencies is actually close to its average level over a 30-year period. Historically, an overvalued currency needs to under shoot its fair value by a wide margin in order to reduce a country's external deficit, but so far the real broad trade-weighted dollar has come off only 15% over the past couple of years.

From its peak in 1985, the dollar dropped by a third, but the US current account deficit is much larger now than it was in the 1980s. Conclusion: over time the dollar has a long way to drop, perhaps destined to lose over 30% of its current value, thus pushing the euro exchange rate to over $1.80. Moreover, the US current account deficit won't be corrected with a fall in the dollar alone. Americans will again need to begin saving at meaningful levels.

Foreign exchange traders in Japan and China are especially becoming unnerved by the dollar these days. Japan's US dollar holdings have reached $817 billion (90% of foreign currency reserves) and China's exposure at $600 billion (35% of foreign currency reserves) is not far behind. Both countries are pressuring the Bush Administration to balance the American budget and improve domestic savings rates. That, however, is going to be next to impossible to achieve.

Consumer spending represents two-thirds of the $11 trillion American economy. That spending contribution has propelled the economy for years. Personal savings sit at a near record low of 0.2% of after-tax income. The average American household now spends 13% of its after-tax income to pay off debts, the highest in almost twenty years. American households are scrambling to pay mortgages and car loans, and are carrying more than $8,000 in credit card debt. So it comes as no surprise that an American declares bankruptcy about every 15 seconds, five times the rate of 25 years ago.

It is unrealistic to assume that Americans' buying binge will end anytime soon, and that people will turn from spenders to savers. America's large budget deficits are also here to stay, fueled by the tax cuts and the $200 billion (and growing) price tag on the Iraq war. So there is little prospect of getting America's financial house in order. In fact, financial disorder is programmed into the future, which means the dollar's position in the world should continue to erode and may reach the point where foreigners won't finance the deficit without much higher interest rates.

The dollar, in the midst of that type of crisis, would collapse, taking the stock market with it and ushering in an ugly US recession, which would engulf the global economy and create a tumultuous foreign exchange market. A tumbling dollar would especially put upward pressure on the euro. Also, Asian economies would be distressed as their currencies strengthened, and their domestic demand would be stimulated to compensate for dwindling exports.

The period ahead looks like it will be one of fierce competitive currency devaluations among the world's major economic forces. In a world where confidence in any paper currency is really just suspicion asleep, there will be a lot of suspicious participants in the FX markets, who will remain permanently awake.

Great fortunes will be made in foreign exchange markets by a small known contingent of tried and tested professional foreign exchange traders and money managers. But the bulk of the world's population, due to a lack of know how, will end up being hurt by the tumultuous period rather than benefiting from it.

The US dollar is likely to end up toppled as the world's reserve currency, perhaps replaced by a temporary hodgepodge basket of currencies centered on the euro. But make no mistake about it, irreversible damage to confidence will be inflicted on the world's paper currency system and the stage will be set for the inevitable repudiation of all unbacked paper currencies. Eventually, a new system of currencies centered around gold will be initiated, and confidence will then be restored and suspicion will be asleep, at least until some other future generation also tries to substitute paper for gold.

Barry Downs: tel: 775 852-3875
bdowns@aegiscap.com
Bill Matlack: tel: 201 217-5680
bmatlack@aegiscap.com

Barry Downs and Bill Matlack are stockbrokers specializing in gold and mining equities with Aegis Capital Corporation, a registered broker/dealer, in New York, New York.

Company Risk Disclosure
In addition to the risks involved in investing in commodities generally, we also highlight the following risks that pertain to this commodity. Gold is highly levered to the relative strength of the U.S. dollar, the U.S. balance of trade, and inflation generally, as well as to political and economic stability worldwide.

Analyst's Certification
We, Barry Downs and William Matlack, hereby certify that the views expressed in this report accurately reflect our personal views about the subject commodity. We also certify that we have not, are not, and will not receive, directly or indirectly, compensation for expressing the specific recommendations or views in this report.

General Disclosure
The research analysts (or their household members) who prepared this research beneficially own gold securities and physical gold. Aegis Capital Corporation ("Aegis") or an affiliate expects to receive and intends to seek compensation for investment banking services from gold equity issuers within the next 3 months. The analysts who prepared this research report may be compensated based upon (among other factors) investment banking services.

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